What exactly is merger arbitrage?

Merger arbitrage, sometimes seen as a hedge fund technique, is simultaneously purchasing and selling the respective stocks of two merging companies to generate “riskless” profits. Because the deal’s completion is uncertain, the target company’s stock often trades at a discount to the acquisition price. A merger arbitrageur will assess the likelihood of a merger failing to close on time or at all and will then buy the stock before the acquisition, intending to profit when the merger or acquisition is completed.

Recognizing Merger Arbitrage

Merger arbitrage, or risk arbitrage, is a subcategory of event-driven investing or trading that involves taking advantage of market inefficiencies before or during a merger or acquisition. A conventional portfolio manager frequently focuses on the merged entity’s profitability.

Particular Considerations

When a corporation announces its intention to purchase another corporation, the acquiring company’s stock price often falls while the target company’s stock price rises. The purchasing corporation must offer more than the current share value to secure the target company’s shares. The acquiring firm’s stock price falls due to market speculation about the target firm or the price proposed for the target firm.

However, the target company’s stock price often remains lower than the disclosed acquisition price, reflecting the uncertainty of the transaction. Investors typically take a long position in the target company in an all-cash merger.

If a merger arbitrageur believes that a merger agreement will fail, the arbitrageur may sell short shares of the target company’s stock. When a merger deal falls through, the target company’s share price returns to its pre-deal price. Mergers can fail for various reasons, including restrictions, financial instability, or unfavorable tax ramifications.

Merger Arbitrage Types

There are two sorts of corporate mergers: cash mergers and stock mergers. In a cash merger, the acquiring business pays cash for the target company’s shares. On the other hand, a stock-for-stock merger involves the exchange of the acquiring company’s stock for the target company’s stock. A merger arbitrageur often buys shares of the target company’s stock while shorting shares of the acquiring company’s stock in a stock-for-stock merger. Suppose the transaction is completed and the target company’s stock is converted into the acquiring company’s stock. In that case, the merger arbitrageur may utilize the converted stock to cover the short position.

A merger arbitrageur could also use options to imitate this technique, such as buying shares of the target company’s stock while buying put options on the acquiring company’s stock.

On the other hand, merger arbitrageurs are concerned with the likelihood of the acquisition being authorized and the length of time it will take to complete the transaction. Merger arbitrage is risky because there is a chance the deal will not be authorized.

Conclusion

• Merger arbitrage is a way to trade in which someone buys the stock of two companies that are joining simultaneously.
• Merger arbitrage takes advantage of the fact that mergers and acquisitions aren’t always good for business.
• Risk arbitrage is another name for merger arbitrage. It is a type of event-driven trading or investment that includes taking advantage of inefficiencies in the market before or after an acquisition or merger.